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Is Your Venture A Business Or A
Hobby?
How to avoid the pitfalls of being labeled a "hobby" by the IRS |
| You may have a "side" business that is not your main
source of income, but provides you a combination of pleasure and
profit potential. So often many hobbies become very successful
business ventures, but while these are becoming successful and
thriving businesses, are you taking the necessary steps to
legitimize the deductions on your tax return? Maybe your
business has future profit potential, and that potential might
be met sometime in the future. Sure it's generating losses now,
but one day, it's going to make you rich. If your "hobby"
business continues to show a loss year after year
while raising horses, playing music, cooking,
performing aerobics or operating any side business,
these will draw IRS scrutiny, especially with the
IRS' new initiative to close the tax gap.
The IRS will disallow losses claimed if they deem
the business to be a hobby versus a real business.
Here are some basics you should consider: |
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| Is it a business or
just for fun? The IRS will generally
assume a business is not a hobby if it showed a
taxable profit in three of the previous five tax
years (two out of seven years for horse breeding and
other horse-related activities). If you are
questioned before this time frame has elapsed, you
can file Form 5213 within 60 days of receiving an
IRS notice to delay the determination until the end
of the fourth tax year (sixth year for horses). Be
aware, however that Form 5213 also extends the
statute of limitations for that activity.
Just because the business isn't showing a profit
does not preclude the loss from being deductible. It
simply becomes a little more trickier to prove the
profit motive.
The IRS has provided guidance on what factors it
will use to determine whether a business with a
taxable loss is actually a for-profit venture:
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Does the time and effort put into
the activity indicate an intention to make a profit?
Does the taxpayer depend on income from the
activity?
If there are losses, are they due to circumstances
beyond the taxpayers control, or did they occur in
the start-up phase of the business?
Has the taxpayer changed methods of operation to
improve profitability?
Does the taxpayer or his/her advisors have the
knowledge needed to carry on the activity as a
successful business?
Has the taxpayer made a profit in similar
activities in the past?
Does the activity make a profit in some years?
Can the taxpayer expect to make a profit in the
future from the appreciation of assets used in the
activity?
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You might think that your hobby is a business
and you might want to treat it as such. Just be
careful that you take the steps necessary to treat
it as a business. Here are some suggestions to help
ensure that your hobby business will be considered a
business for tax purposes:
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Open a checking account for the
business separate from his personal account.
Keep track of your income & expenses in a ledger.
Take a class or attend a seminar on how to make
his business profitable.
Document an annual plan that includes goals for
the year to make the business profitable.
Set up a budget for the business and/or a
projection showing profitability in future years.
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| Remember, many of today's successful businesses
had their beginning as a small, garage/home oriented
business that started as a hobby while the
entrepreneur went to school or worked full-time at
another job. So, don't be discouraged if your
business doesn't have the immediate success you have
dreamed about. If it's a good idea stay with it and
you will be successful. |
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